United States Supreme Court Determines That Partnership Determinations Affecting Outside Basis Of A Partner Are Subject To The TEFRA Entity Level Audit Rules In United States v. Woods

On December 3, 2013, a unanimous Supreme Court, in an opinion written by Justice Scalia, held that whether a gross valuation misstatement penalty with respect to a partnership tax item could be imposed was to be determined in a partnership level proceeding under the TEFRA audit rules. 112 AFTR 2d 2013-6974 (2013), In reversing the Fifth Circuit, the Court upheld the imposition of a 40% gross valuation misstatement as to the inflated claimed outside basis of partners holding partnership interests in an abusive tax scheme who claimed large tax losses based on such erroneously inflated basis.

Background

Prior to 1982, the Service was precluded from making adjustments in correcting a partnership's informational return and resolving a dispute about such proposed partnership-level adjustments in a single, unified proceeding. Instead, auditing and adjusting partnership tax items were resolved at the individual partner level, i.e., through deficiency proceedings at the individual-taxpayer level. See generally §§ 6211-6216. Under a deficiency proceeding, the IRS is required to timely issue, prior to the running of the statute of limitations on assessments, including extensions, a separate notice of deficiency to each taxpayer under §6212(a) in which case the taxpayer has a 90 day period to file a petition in the United States Tax Court to challenge the alleged deficiency before the tax can be assessed. See §6213(a). It is also possible for the TMP to decide in proceeding before the Federal District Court having venue of the matter or with the Court of Federal Claims. These procedures applied as well to partnership income tax adjustments prior to the enactment of the partnership entity level audit rules in the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. 96 Stat. 648 (26 U.S.C. §§6221-6232]. The need for partnership level determinations was enacted into law by Congress to remove the cumbersome and difficult process faced by the Service in chasing down each partner based on his or its place of residence. The potential always existed for inconsistent determinations among different partners, most particularly where the partners in question resided in different circuits.

Under TEFRA, partnership-related tax matters are involved in a two part process. First, the IRS commences the audit at the partnership level to adjust "partnership items," as defined. See §§ 6221, 6231(a)(3). Where the treatment of certain partnership items is contested by the party acting on behalf of the partnership, e.g., the tax matters partner, the Service is required to issue a final partnership audit adjustment report or FPAA...